Ballantyne Re bonds, so far, survive Scottish Re cataclysm

Credit analysts see no reason - for now, at least - to downgrade the high-profile $2.1 billion Ballantyne Re securitization, despite the fact that the issuing entity, Scottish Re, suffered a series of downgrades that reduced its counterparty credit rating to junk status and its stock price is languishing at yearly lows.

All three major credit rating agencies weighed in on the transaction when it priced in late April. The proceeds from the transaction allowed Scottish Re, to meet capital requirements under Regulation XXX. Ballantyne Re priced in late April, with Lehman Brothers acting as lead manager.

Several months after the securitization closed, Scottish Re's troubles bubbled to the surface. Several days before its second quarter earnings announcement, President and CEO Scott Willkomm resigned. The company went on to report dismal second-quarter results, saying that it suffered a net operating loss of $130.3 million for the second quarter, a result of a change in complex tax-planning strategies. In late July, the company suspended its dividend and hired Goldman Sachs and Bear Stearns to explore a possible sale or infusion of investor capital for the company. The rating agencies spoke up in mid-August, when Fitch Ratings, Moody's Investors Service, Standard & Poor's and Oldwick, N.J.-based insurance rating agency A.M. Best all slashed the company's credit rating, some down to junk status. Further, the company is facing several class-action lawsuits alleging that it made false statements to cover up its financial difficulties, which inflated its stock price.

Despite the fact that Ballantyne Re's performance hinges entirely on that of Scottish Re, the credit ratings on the securitization have not changed.

"Intuitively, we were uneasy," said Donald Thorpe, senior director of insurance ratings for Fitch Ratings. "Scottish Re is Ballantyne Re's only customer, so you get worried. But based on the current information, there was not a scenario that would occur to damage the deal."

Essentially, Ballantyne Re finances all of Scottish Re's reinsurance contracts with one entity, Denver-based, underwriter Security Life of Denver. The multilayered deal features several structural enhancements that shore up analysts' confidence in the deal's integrity. Scottish Re is prevented from inappropriately redirecting funds pledged to Ballantyne Re. If Scottish Re diverts any funds from Ballantyne Re, the proceeds go into a trust fund, and Security Life of Denver has 10 days to raise any objections that it might have.

Fitch Ratings also examined whether Scottish Re's ongoing problems might trigger what the insurance industry calls adverse selection, wherein policyholders regarded as good risks allow their policies to lapse, leaving the deal's chain of insurers and reinsurers with the so-called bad risks. Security Life of Denver underwrites risk for 23 primary firms that sold the deal's underlying policies to individuals. Fitch reasoned that the 23 primary firms that brokered the underlying insurance policies - such as Met Life - served customers who were unfamiliar with Scottish Re, therefore the company's troubles might not motivate them to take their business elsewhere.

Likewise, the 23 primary insurance companies that sold their policies to Security Life of Denver were not likely to cancel their contract with the double-A rated company.

"Security Life of Denver wanted these protections, because they are on the hook, even if they are not getting paid," Thorpe said.